Monetary Policy and Forex Markets
Central banks frequently intervene in forex markets to achieve certain monetary policy goals. Successful interventions require an in-depth knowledge of market dynamics, and correct timing is crucial.
An effective way of manipulating exchange rates is through changing the monetary base – this method is known as sterilized intervention; for non-sterilized intervention, buying or selling foreign currency are methods used.
Contents
Definition
Monetary policy refers to a nation’s monetary management strategies and goals. The central bank controls money supply and short-term interest rates which in turn impact longer-term interest rates and economic activity. Monetary policy serves an integral function in stabilizing inflation which many advanced economies have set as their explicit objective.
Currency intervention refers to direct intervention by the monetary authority into foreign exchange markets to influence their exchange rates. They may utilize sterilized or non-sterilized interventions depending on whether foreign exchange transactions change the monetary base. Either way, however, intervention policies must clearly define their goals with this goal in mind; otherwise expectations could shift unexpectedly leading to instability and sudden fluctuations in exchange rate levels.
Timelines for intervention are also significant. Central banks typically intervene in the foreign exchange market through day-to-day or even shorter-term operations, and as a result studies using long timeframes (i.e. months or more) may fail to detect any effects from interventions.
Time horizon
Central banks use interest rate adjustments, asset purchases and inflation targets as tools to manipulate a country’s currency. Such decisions have direct repercussions for forex prices; traders must understand monetary policy in order to anticipate and react appropriately when facing such shifts in monetary policy.
Timeliness of intervention policies is an integral element in their effectiveness. Short-term interventions may aim at altering day-to-day exchange rate volatility; longer term policies could alter expectations about long-run equilibriums and thus should have specific aims that complement other monetary policy objectives.
Central banks typically establish inflation targets, or acceptable levels of inflation for an economy. The goal is to achieve stability as high inflation can erode consumer and business trust in an economy and lead to slowdowns, job losses and financial crises – something any trader considering investing in forex must keep in mind when making their decision.
Momentum
Momentum plays a critical role in FX intervention’s effectiveness. If traders believe a central bank recently succeeded in lifting its currency, they may continue to believe it can do so again in future. Announcing an intervention often triggers private capital movements – including sales or purchases of foreign currencies or bonds that replicate its effect – acting similarly as official interventions would.
Non-sterilized intervention refers to the use of monetary policy tools that alter the monetary base without changing exchange rates. Authorities may do this by purchasing foreign-currency bonds while selling domestic-currency ones simultaneously. Thus, this type of intervention should have no net effect on the monetary base; however, its potential to increase market volatility and make achieving monetary policy goals difficult can make this option risky. Table 2 illustrates that success criteria for interventions are relatively straightforward: The goal must be credible, while its target must not conflict with other policy goals (such as money supply growth or international reserves). Furthermore, size matters greatly for successful intervention strategies.
Sterilization
Sterilization occurs when a central bank intervenes in the foreign exchange market and neutralizes any effect it might have on domestic money supplies by selling bonds on domestic markets to absorb additional demand for money created by purchasing foreign currency; this method is commonly known as draining.
Imagine that a central bank intervenes in the foreign exchange market to defend against depreciation of its currency. Under such conditions, domestic interest rates would likely exceed international ones; market participants may opt to borrow foreign currencies before lending back in domestic currency which puts downward pressure on local rates.
Sterilized forex interventions may be sustained without negative financial repercussions provided that annual purchases do not exceed 5% of its foreign reserves stock and the CB remains committed to its policy implied by intervention activity; otherwise, its level of monetary autonomy will diminish significantly.
